Plausibility

Long post today, because I have literally lost sleep in the last couple of weeks over what will happen here in the months that follow. There will be a political riff in November, and the economic consequences need to be considered. Along with countless articles online, I have been reading Crisis Economics by Nouriel Roubini (aka Dr. Doom), one of the first economists to blow the whistle on the upcoming crisis back in 2006, and in fairly accurate detail. I'm still reading, but at this point I would highly recommend the book. Chapter two gives a brief but in depth review of economic theories and the theorists behind them. He runs through where we came from, what we've learned, where we've failed, and where we are presently. Right now we are at a truly incredible moment in history where there are two main schools of thought with completely opposite conclusions vying for credibility. I will attempt to outline the two here.

The Austrian school of economics preaches against unsustainable debt, and against government intervention. They argue that debt begets more debt, and government intervention will only lead us down the path of ever increasing debt which will eventually lead to a collapse of our system. Looking at our history of government intervention, it is hard to argue that this observation is incorrect. We see increased debt, masked by inflation and the break from the gold standard, and increasingly lax fiscal and monetary policy since the Great Depression. To prove its modern applicability, this most recent bust could be attributed to Greenspan's federal reserve keeping interest rates too low for too long in reaction to the 2001 tech bust, leading to money being too easily available, an excessive lending boom and a speculative bubble in real estate, then before we've recovered from that recession we catapult into stimulus for the next recession. It's never ending!

So, if these Austrians are so on the ball, why don't we do what they recommend: cut spending, raise taxes, and bring down the debt?

At the core of the Austrian school of economics is the concept of "creative destruction." This term is used to describe the need for economies to be torn down and brought up from the ground, having filtered the weak links out. In other words, the Great Depression was the correct reaction to our over speculation prior to that bust. The difference being that rather than using government money to stimulate the economy, we should be left to slowly crawl out on our own. This to me, is the truly logical solution. The weak perish, the strong survive, and we come out of the flames with a smaller, leaner, more efficient economy... oh and by the way there is NO limit to the number of allowed casualties. The economy comes back when it is deserving. Logical, but totally lacking in regard for society, and lord knows where that would leave us politically. We have enough turmoil without the depression.

The Libertarian school of thought is the same, but is in denial of the inevitable destruction caused by the deflationary spiral. For an excellent illustration of just how much deflation spirals on itself, take a look at Ireland, the first of the European countries to enact the austerity measures similar to those recently agreed upon by the rest of Europe at the G20 meeting in Toronto. Here's what's going on RIGHT NOW: Ireland enacted austerity measures 2 years ago (around the same time we started stimulus), and now their unemployment is up to 13.7%, they're still in a recession, their credit rating crashed, wages were cut, and what's worse is their debt as percentage of GDP has more than doubled from roughly 25% to 80%. As a basis for comparison, our debt has risen from roughly 65% to 90% since the beginning of stimulus in 2008, only the last 10% coming during Obama's term, but that number continues to grow. We're both at similar debt/GDP ratios and both are still rising, but we're no longer in a recession, have falling unemployment, and have a good credit rating... oh and we started at a much higher debt level. Ireland vs the US may be apples to oranges, but this is something to consider.

So if the Austrians are right, but have a far too painful remedy, and the Libertarians are just Austrians who are fooling themselves, what's the other option? The other main school of thought on the table is Keynesian economics. Keynesian theory is that in the presence of a crisis, the government should swiftly step in with stimulus targeted at restoring aggregate demand and supplementing liquidity to halt the recession. This stimulus needs to stay in place until confidence has been restored to the system, the recession has been transformed into stable growth, and business as usual is restored. As the recession turns to steady growth, the stimulus should be pulled back gradually to manage inflationary forces. The debt accrued during the stimulus period is slowly repaid during a period of steady inflation, during which time the value of the debt has been gradually decreasing, and more importantly the GDP has been growing.

The problem with this school of thought is judging the duration and severity of the stimulus required. It's like planning a hike across the desert and trying to decide how much water to bring. Too much and you get weighed down, too little and you die of dehydration, and the main problem is that you have no idea how large the desert is. That is the situation we're staring at right now (a good analogy which shows my skepticism of common sense simplicity). Also, Keynesian economists are lousy at judging how to pull back because they're afraid of freaking out the market which has grown dependent on their government safety net. Then when the next recession hits, we're still reeling in debt from the previous one! This is where the infinite inflation scenario comes from.

What Roubini says is that both schools are correct, and it's a darn shame that they fight rather than talk with each other. There is a time and a place for both. During recovery it is critical to stop the fall of the market and encourage growth the way the Keynesians know how to do. Then there should be a firm, but not premature transition to Austrian austerity as the economy flourishes. This cooperation of the two schools is the best possible solution... but improperly timed may be the worst. The WORST possible solution is an attempt at Keynesian recovery, only to be stifled by Austrian austerity at the first sign of the recovery. Then you get Keynesian debt and Austrian "creative destruction." ... Yes, OH SHIT indeed! The worst of both worlds. That is why the treasury and Fed remained firm just prior to the great depression, that is what happened in Japan during the lost decade (except they still held onto some of the stimulus, resulting in stagflation rather than all out depression... almost as bad), and that is what it looks like we're about to do.

Which brings me to the title of this post. In November there is very likely going to be a shift of power, largely due to paranoia and the "common sense" rebellion against the "socialist" Obama administration. The primary purpose of this post is not to convince the conservatives that Obama is doing the right thing. 1) That's a futile effort, and 2) I don't know if he is or isn't, because Keynesian theory isn't money magic, it largely depends on how you spend the money and how you exit the recovery strategy. My point here is to present the two realistic schools of thought, their respective advantages and drawbacks, and to at least introduce the possibility that a) Obama is at least aware of both sides of the argument and went with the more commonly believed school, b) we could possibly be doing the right thing already, and c) that the premature switch from one school to the other could potentially be catastrophic. You may not BELIEVE all of that, but it should at least be plausible.